While much attention has focused recently on the immense cost of pension benefits for government workers, an
equally challenging problem has received much less discussion: the cost of retiree health care. This paper examines the
ongoing fiscal crisis caused by health-care plans for retirees (known as "other post-employment benefits," or OPEB) in
one of the hardest-hit states: California. Already, government workers' retirement costs have played a role in municipal
bankruptcies in Stockton, San Bernardino, and Vallejo, and the pressure will only intensify as more workers retire in
coming years. Collectively, California state and local governments face an unfunded retiree health-care liability of at
least $130 billion. Few governments have set aside sufficient funds to pay for these future costs.

Retiree health benefits in the public sector can exceed $20,000 a year per person in value. Even the most basic form of
government-employer-sponsored OPEB is more generous than what most private-sector retirees receive. In fact, only
25 percent of large American employers offer retiree health care; in the public sector, 77 percent of employers do so.

Fortunately, we now have a window of opportunity for effective OPEB reform in the public sector because state and
local governments' retiree health-care programs are relatively undeveloped. Pension obligations are often set in stone,
but in the realm of OPEB, many important decisions have not yet been made regarding benefit structures, cost-sharing
and funding arrangements, and the legal status of benefits. This helps governments avoid repeating the history of
pension commitments, which locked governments into rigid and unsustainable benefit commitments.

OPEB is essentially a fiscal problem, and new revenues will be necessary to support these benefits. But it would be a grave
mistake to simply fill in the fiscal gap with more taxpayer money. Instead, reform should precede revenue (especially
since some reforms may generate revenues). Governments that seek to pay for OPEB only with taxes or budget cuts
are being neither practical nor fair.

What is to be done? What actions should state and local governments take to manage OPEB? This paper describes the
current crisis, analyzes current OPEB practices and their contribution to the problem, and outlines necessary reforms
that should come before tax increases or cuts to government services. These reforms are:

(1) California state and local governments should reassess the need to offer OPEB. Before restructuring their
OPEB program, all governments should first evaluate the importance of this benefit. Are retiree health-care benefits
necessary to attract and retain a skilled workforce? Cities such as Fresno, which never allowed its OPEB programs
to become overly generous, now have manageable long-term liabilities. Governments should understand that they
may have more flexibility to adjust retiree health-care benefits than they have for pensions, as was demonstrated
in recent litigation between Orange County and its retirees.

(2) Think hybrid. California cities should consider a hybrid model for OPEB, similar to the hybrid pension models
recently adopted in Rhode Island, Utah, and the city of San Jose. Hybrids provide retirees with a basic level of
retirement security while reducing employers' overall liability.

(3) Raise revenues and begin prefunding. A few governments have shifted from pay-as-you-go methods to a
prefunded approach to OPEB (in which benefits are paid by money set aside and invested for that purpose, as is
done with pensions). This trend must accelerate and become widespread. The move to prefunding will require
that more money go into retiree health benefits. Who should provide it? The first and most obvious candidates
are the employees who will benefit. Currently, most California government employees do not contribute to their
retirement health-care benefits at all. They should be required to contribute half their OPEB's actuarial normal
cost—the amount set aside each year to ensure that the benefit will be adequately funded when the employee
reaches retirement. Of course, all new revenues raised by this or any other method should be deposited into an
irrevocable trust fund and invested.

(4) State government should provide local governments greater bargaining leverage for OPEB. With the
pension reform signed into law in September 2012, California state government requires that public employees
pay half their pension costs, with their government employers picking up the rest. This 50/50 split is defined as the
California standard, and local governments have the authority to implement it in cases where collective bargaining
has come to an impasse on pension issues. This reform should be extended to OPEB.

About the Author

Stephen D. Eide is a senior fellow at the Manhattan Institute's Center for State and Local Leadership. He was previously
a senior research associate at the Worcester Regional Research Bureau. He is a regular contributor to PublicSectorInc.org,
a project of the Manhattan Institute. His work focuses on public administration, public finance, political theory, and urban
policy. His work has been published in the New York Post, Worcester Telegram and Gazette, Worcester Business Journal,
Commonwealth Magazine, Boston Herald, Interpretation: A Journal of Political Philosophy, and Academic Questions.
A native of Richmond, Virginia, Eide holds a bachelor's degree from St. John's College in Santa Fe, N.M., and a Ph.D. in
political philosophy from Boston College.

I. OPEB: THE NEGLECTED FISCAL MENACE

Most California local governments provide health-care
benefits to their retirees (OPEB).
[1]
A 2008 survey of
almost 1,200 public agencies in California found that
82 percent provided OPEB.
[2]

This is in stark contrast to the private sector. According to the most
recent edition of the Kaiser Foundation's annual "Health Benefits
Survey,"
[3]
98 percent of large (200+ employees) American employers
offer health benefits to their current employees, but only 25 percent
offer retiree coverage. In contrast, Kaiser reports that this figure for
state and local governments is 77 percent.

Private-sector retiree health benefits are largely confined to big employers. In fact, the larger a corporation is, the more likely it is to
offer retiree health benefits. According to the Agency for Healthcare
Research and Quality, 38 percent of private-sector establishments
with more than 1,000 employees provide health insurance to retirees
under the age of 65, and 32 percent provide it to retirees who are
over 65.
[4]
To put these figure in perspective, out of the 50 biggest
cities in California, 25 have more than 1,000 employees. Yet nearly
all offer OPEB.
[5]

Though pension costs claim the lion's share of media
attention about government's fiscal troubles, OPEB is
a major challenge. According to a recent analysis by
the nonpartisan research group California Common
Sense, California state government's annual OPEB
bill grew over 400 percent, from $300 million to
$1.6 billion, between 1999 and 2011.
[6]
Among the 20
largest cities in California, OPEB costs increased, on
average, 36 percent in only a three-year span between
the 2008 and 2011 fiscal years, and some cities saw
increases of more than 50 percent. At these rates, it
has been estimated that OPEB costs will consume
some cities' entire budgets in 20–30 years.
[7]

Our focus is on California; but nationally, the OPEB
picture is equally bleak. The Pew Center on the States'
most recent estimate of American states' total OPEB
liability was $660 billion, $627 billion of which is
unfunded.
[8]
This is not much lower than the states'
unfunded pension liability, which, according to Pew,
is $757 million (though this figure may be overly
optimistic, based, as it is, on the states' own rosy
estimates of future performance). The State Budget
Crisis Task Force estimates American state and local governments' collective OPEB liability to be at
least $1 trillion.
[9]
For comparison, state and local governments' unfunded pension liabilities amount
to $1 trillion–$3 trillion, depending on actuarial
assumptions.
[10]

Retirement benefit costs (pensions and OPEB) are
squeezing out other priorities in California. Charts
1 and 2, based on data collected and organized by
former state economic official David Crane,
[11]
illustrate this trend.

Much of California state government spending is
nondiscretionary, mandated by various laws and
obligations. Charts 1 and 2 show major categories
within that part of the budget over which the government does have discretion; these account for over 80
percent of total discretionary spending. A comparison
between the two charts illustrates the growing burden
of payments to retirees—OPEB as well as pensions.
As the charts show, over a quarter (28 percent) of
this spending will be devoted to retirement benefits
in fiscal year 2013. That is up 3/4 the percentage in
2003 (16 percent).The impact of this increase has
been felt in cuts to universities and other services,
higher taxes in 2009, and proposed tax increases in
2012. The challenge of public-sector employment
costs, then, isn't just a matter of pensions. There is no surmounting the fiscal problem without an understanding of OPEB and its impact.

OPEB MECHANICS

Retiree health benefits come in a few different forms,
which may be sorted into two groups: those provided
to pre-Medicare, or early, retirees; and those for
Medicare-eligible retirees.

Pre-Medicare-eligible

• The most basic form of retiree health-care
benefit is simple: letting workers stay on
their workplace health plan after they retire.
For retirees too young for Medicare, this offers significant savings. Instead of having to
purchase non-group health insurance in their
late middle age, they can pool their risks with
younger active employees, and their premiums
are lower. This benefit is known as an "implicit
rate subsidy." The value of the implicit rate
subsidy to a retiree increases with age. In San
Jose, for a 64-year-old on the verge of Medicare,
the value is typically $5,000–6,000 a year.
[12]
Most private-sector employers do not offer this
benefit, since it increases costs for employers as
well as for active employees. Some California
local governments only offer this benefit.

• Many governments also provide early retirees
with an explicit subsidy, either through a flat
stipend or picking up a certain share of the
employees' premium for new health coverage
after they leave the employee plan. Depending
on the subsidy's value, this is potentially the
costliest of all retiree health benefits.

Medicare-eligible

• At age 65, the burden of funding retiree health
care shifts from the employer to the federal
government's Medicare program. Medicare has
three parts: A, B, and D, all of which require
cost-sharing. Unlike most private insurance,
Medicare does not offer a guaranteed cap
on out-of-pocket costs for the individual. To
manage Medicare's out-of-pocket costs, many
retirees purchase supplemental, or Medigap,
insurance from a private carrier. Another option
is to enroll in Medicare Part C, a Medicare Advantage plan, through which federally funded
private insurance replaces and supplements
Medicare. Because the federal government
assumes primary responsibility for most costs,
Medicare supplemental benefits are much less
expensive than coverage for pre-Medicareeligible retirees. However, it is less common for
an employer to provide them.
[13]

• Some employers pick up the cost of Part B
premiums (currently about $100 per month
for most retirees).

OPEB may also include health care for dependents
and survivors, along with vision, life, and dental
insurance.

Table 1 details the retiree health benefit packages
provided by California state government and the five
biggest cities in the state.
[14]

OPEB benefits in California are employer-specific,
and governments have wide latitude over what to offer. While California and other states have statewide
systems for pensions (such as the California State
Teachers' Retirement System and the New York State
Employees Retirement System), California has no
such standardized approach to OPEB. Hence OPEB
comes in a greater variety than pensions. Some retirement systems are extremely generous; some offer no
retiree health benefits at all.
[15]

The important exception to the general rule of OPEB
diversity is the influence of the California Public
Employees' Retirement System, or CalPERS. Best
known for running California's $226.6 billion pension fund,
[16]
CalPERS also manages health care for
state employees and retirees. It is also involved in local
governments' OPEB because governments may contract with CalPERS to manage health care for their
employees and retirees, through what is known as the
Public Employees' Medical and Hospital Care Act
(PEMHCA) program. More than 1,100 local governments (out of a state total of 4,350)
[17]
participate,
covering 421,709 active local government employees
and their dependents, as well as 137,370 retirees and
their dependents. The benefits to local governments
are CalPERS' low administrative costs, access to a
wide range of plan offerings, more risk pooling, and
access to CalPERS' massive purchasing power—in
2011, CalPERS spent $6.7 billion on health care, a
sum second in the United States only to the federal
government's medical spending.

Contracting governments must sacrifice some
freedom over their benefit structures to participate
in PEMHCA. Most notably, PEMHCA requires
that "[t]he employer contribution shall be an equal
amount for both employees and annuitants."
[18]
A
government that does not contribute equal amounts
to active and retired workers' health care may still
join but, over time, must gradually equalize its contributions. PEMHCA sets a minimum employer
contribution, currently $112 per month.
[19]

CalPERS also assists local governments to fund
OPEB. In March 2007, the state legislature authorized CalPERS to establish the California Employers' Benefit Trust (CERBT), a collective, irrevocable
trust through which local governments may pool
and invest funds for OPEB. Governments need not
contract with CalPERS for health benefits to participate in CERBT.
[20]
As of July 2012, 338 agencies
had joined, and the trust had $2.1 billion in assets
under management.
[21]

The variety of types of benefit packages among
California's local government units makes it difficult
to speak generally about OPEB. But at least three
generalizations are warranted:

1. Even the sparest forms of OPEB (implicit rate
subsidy, Medicare Part B pickup) are more generous than what most private-sector employers
provide. In California, only 12 percent of all
private-sector establishments offer health insurance to early retirees (55–64).
[22]

2. In California, scales that define OPEB eligibility (Table 1) tend to be much more compressed
than those for pensions. In many communities,
an employee qualifies for minimum OPEB after ten or fewer years of service. Moreover, this
minimum benefit is often fully 50 percent of the
maximum, for which only ten more years are
needed to qualify. Pension systems use a more
graduated eligibility scale, so that it takes much
longer than 20 years to max out for non-publicsafety employees.

3. OPEB liabilities tend to grow. Retirement systems reevaluate their liabilities every two years,
and, almost inevitably, OPEB estimates increase
because more workers have qualified for benefits,
and the value of those benefits has risen with
the ever-mounting cost of health care. Most
OPEB systems are pay-as-you-go, so they have
no investment return to narrow the gap between
assets and liabilities. As a general rule, OPEB
costs have nowhere to go but up.

To grasp the fiscal and political impact of OPEB,
it is important to understand how these benefits
differ from pensions. Four distinctions matter for
policymakers.

First, pensions are more valuable than health-care
benefits, which is one reason they get much more
attention. The most conceivably generous retiree
health-care benefit—an employer picking up 100
percent of the premium for a family plan for a preMedicare-eligible retiree—would still tend, in dollar
value, to be less than the average pension benefit in
most systems.

For example, the current average pension for all CalPERS retirees is $28,000 a year, and
it is $37,000 for those retiring in the past year.
[23]
The
average pension for all retired California teachers is
about $49,000.
[24]
By contrast, the Affordable Care
Act's official definition of "excessive" (or "Cadillac")
spending on a family plan for 55–64-year-olds is
$30,950. At age 65, when Medicare kicks in, the cost
of a beneficiary's OPEB drops.
So, compared with OPEB, pensions cost more and
are a more familiar political issue. Then, too, certain
outrageous abuses are possible with pensions that
are not possible with OPEB. "Spiking"—manipulating the benefit formula to increase payments, as
when, for example, a worker adds pay for unused
vacations to his last year's salary to increase the basis
of his pension—has no equivalent in the OPEB
world. There is no OPEB equivalent to the media
story about the "$100,000 club"
[25]
of retirees with
enormous pensions.

It is important to remember that this lack of attention to OPEB is simply a consequence of this way
in which health benefits differ from pensions. As
we have mentioned, OPEB is a significant cost for
governments and an exceptionally generous benefit
for retirees. An OPEB benefit of $415 a month for a
retiree is a much smaller expenditure than a monthly
pension check, but this should not obscure the fact
that such a benefit (quite typical in California) far
exceeds what is expected in the private sector.

Employees and unions will fight hard to keep OPEB
as it is because paying for health care lately has become
more expensive for retirees in general. Even Medicare
costs more than it did for earlier generations. For
example, out-of-pocket expenses for Medicare Part
B, which were only 7.5 percent of the average Social
Security benefit in 1983, are now 17 percent.
[26]
According to AARP, Medicare beneficiaries in California spent
an average of $4,000, 15 percent of their income, on
all out-of-pocket health-care costs in 2011.
[27]

The second way in which OPEB differs from pension
systems is that OPEB promises the same benefit to
each retiree, without relation to salary or rank during
the working years. Janitors' and cafeteria workers'
benefits are equal in value to those of police chiefs and
superintendents. Public-safety workers receive somewhat more benefits on average, only because these
employees tend to retire sooner and draw on OPEB
for longer—there is no premium for risky occupations, and within any given OPEB system, a retired
clerk gets the same coverage as a retired firefighter.
Of course, those who live longest will use the most
health services, but because retirees tend to become
eligible for OPEB sooner than they qualify for pensions, even the natural differences in individual life
spans don't create big differences in the cost of OPEB
from one employee to another.

Third, OPEB's long-term costs are far more uncertain
than pension obligations. A pension is a payment
of a predictable amount every month. By contrast,
health care is a service whose cost changes every year.

Government policy compounds the inherent uncertainty of OPEB costs. At the federal level, two
provisions of the 2010 Affordable Care Act can serve
as examples. One imposes a tax, beginning in 2018,
on exceptionally costly "Cadillac" health-insurance
plans—those whose annual premiums cost over
$11,850 for a single plan or $30,950 for a family
plan. The policy aims to discourage expensive plans
that cover so many services that beneficiaries have an
incentive to overuse the medical system. But its effect
on OPEB systems may well be to increase liabilities.
[28]
To avert that possibility, systems might respond as
legislators hoped: reduce benefits to keep their plans
below the Cadillac cost threshold. However, they
might instead pass on the cost of the tax to retirees. Or
they might simply drop coverage. The ACA provides
another incentive to do so: in 2014, the law's new
state health-care exchanges will go into effect. Some
recent employer surveys have reported that many
private-sector employers view the exchanges, which
are accompanied by generous government subsidies,
as an opportunity to exit their retiree health-care
commitments.
[29]

Another source of uncertainty is potential Medicare
reform. For example, one oft-discussed change to
Medicare would raise the eligibility age from 65 to
67, thus aligning it with Social Security. For state and
local governments, this change would oblige them
to cover two more years of health care for a highly
risk-prone and expensive population.

For the moment, governments have won a reprieve
from the alarming health-care-cost trends of the
2000s. The rate at which costs rise has slowed: family
health-insurance premiums grew 50 percent between
2002 and 2007, but only 30 percent between 2007
and 2012.
[30]
This could be because people have
simply spent less on health care. Employers have
shifted more out-of-pocket expenses to employees,
and the recession has caused households to cut back
spending on all goods and services. It's also possible that health-care costs are down because of enhanced
efficiencies in the health-care system.
[31] Whether this
slowing trend will continue is unpredictable.

A fourth difference between pensions and OPEB is
the most important: since the 1980s, government
pensions have been "prefunded"—each year, governments set aside funds for an irrevocable trust that will
pay for workers' future retirement benefits. Present
taxpayers thereby pay the future retirement costs of
today's workers. OPEB, though, is usually deemed an
operating expense, with government appropriating
only enough funds to cover that year's benefits. With
this pay-as-you-go approach, today's taxpayers compensate retired workers for services rendered decades
ago. Prefunding, of course, is more cost-effective than
pay-as-you-go, since investment return relieves the
pressure on taxpayers and employees, the only other
two sources of funding for benefits. Depending on
the stock market's performance, prefunding can even
allow for decreases in employer/taxpayer contributions to retirement systems.

But the majority of governments don't prefund OPEB
because it's more expensive in the short term. For
example, if California's state government were to
switch today from pay-as-you-go to prefunding for
OPEB, it would have to pay more each year for the
same benefits, and this extra cost would endure for
over 20 years. According to the Center for Retirement
Research at Boston College, prefunded OPEB would
not begin to cost less than pay-as-you-go until 2036.
[32]
Struggling even to fund current retirees' benefits,
governments are understandably disinclined to cut
constituents' services or to raise taxes to cover future
OPEB costs.

Prefunding is certainly a critical part of the solution to
the OPEB problem. But prefunding, no matter how
widespread and no matter how well financed, is not
and cannot be the single simple solution to the OPEB
challenge. The experience of governments that have
taken the first steps toward proper prefunding have
made this clear, as we shall see below. Even adequate
prefunding (of which there are few examples) does
not change the fundamental imperative: reform must
precede revenue.

OPEB: The Costs

Table 2
[33]
provides estimates for unfunded pension
and OPEB liabilities for 50 of the biggest cities in
California.
[34]

Shading in the table marks the 18 governments that
have begun the process of prefunding. Their efforts
are at a very early stage, and most of their funded
ratios (the percentage of liabilities that would be
covered by assets on hand) are low. The median
OPEB-funded ratio among the 18 prefunded systems
is 21.1 percent.

We have indicated the cost per household of OPEB
costs to allow comparison of retirement-related
burdens in different communities. However, these
per-household figures do not represent the total bill
for each family because OPEB liabilities exist at each
layer of government (state, county, school district,
special purpose entity). A household in Los Angeles
thus has a $3,201 bill for the health benefits of retired
employees of the Los Angeles City government, but
it also bears the burden of paying for health benefits
for retired teachers, state university employees, and
employees of Los Angeles County. The University
of California Retiree Health Plan alone faces an
unfunded OPEB liability of $16 billion.
[35] Hence,
for any given home in California, the OPEB burden
likely is thousands more than is found by tallying a
single local government's obligations.[
36]

Overall, California state government's long-term
unfunded OPEB liability is $62 billion, over half the
size of its total bonded debt ($111.5 billion).
[37]
The
unfunded liability for state and local governments
combined is over $130 billion.
[38]
These liabilities are
in addition to state and local governments' collective
pension liability, estimates of which have ranged
from $135.8 to over $630 billion.
[39]
This means that
California cities' "soft" debt (future obligations to
retirees) is either equal to, or slightly more than, the
fixed payments that they must make on bonds and
loans, known as "hard" debt
[40]
(Chart 3).

California, with its spectacular fiscal crises and large
population, is a premier example of the challenge posed by government's OPEB obligations. However,
it is merely one example of a nationwide problem. In
fact, on some measures, the OPEB problem is worse
elsewhere. For instance, California cities' unfunded
OPEB liabilities are smaller than those of cities in
New York.
[41]
The average per-household OPEB liability among New York's top 15 cities (not including
New York City) is $7,946 (median $7,000).
[42]
Among
California's top 15, this figure is $2,962 (median
$2,106).
[43]

II. THE ROLE OF OPEB IN LOCAL FISCAL
DISTRESS IN CALIFORNIA

California state government has been in a sustained fiscal crisis for almost five years. In every
year since 2008, the state government has faced
budget deficits ranging from $10 billion to $30 billion.
[44]
Expressed as a percentage of the total general
fund budget, California's budget deficits have ranked
among the largest of all state governments in both of
the last two years.
[45]
All three credit ratings agencies
have downgraded the state's bond rating by at least two
notches since 2008.
[46]
California now has the lowest
bond rating out of all 50 states.
[47]
A late-August survey
of states' borrowing costs by Barron's found that California's were the second-highest among all 50 states.
[48]

Fiscal crisis at the local level is even more pronounced.
Four California cities have declared bankruptcy since
2008—three in the summer of 2012 alone.

These fiscal problems cannot simply be attributed to
California's weak economy, though that factor must be acknowledged. California is one of only three
American states whose unemployment rate is still
above 10 percent. Of the 14 American metropolitan
areas where unemployment is above 13 percent, 11
are in California.
[49]
California's GDP growth has
trailed most other states in every year since 2008.
[50]
California cities made up seven out of the top ten
metro areas with the highest rates of new foreclosures
in the first half of 2012.
[51]

But economic weakness alone cannot explain government's fiscal distress. Both unemployment and
per-capita income are poor predictors of fiscal distress
in a community, as measured by its percentage of
workforce reduction between 2008 and 2011 (see
Charts 4 and 5). Relatively wealthy communities
and communities with low unemployment rates
have downsized by about the same amount as communities with lower per-capita incomes and high
unemployment rates.

California state and local governments' deficit is more
structural than cyclical. Certainly, high unemployment and the housing collapse have strained budgets.
But cities' spending commitments have left them
unable to adjust to changing economic conditions.
Among those commitments, retirement-related costs
are a major factor.

Unsustainable spending on retirement benefits
has played a critical role in three out of the four
Chapter 9 bankruptcy filings among California cities since 2008.
[52]
In 2009, Vallejo became
the first California local government to use the
federal bankruptcy law's Chapter 9 (reserved for
municipalities) to reduce retiree health-care benefits. Today, post-bankruptcy, Vallejo's benefits are
$300 per month per retiree, down from as high
as $1,500.
[53]
The city of Stockton, which filed for
bankruptcy last summer, intends to go even further: it seeks to eliminate retiree health benefits
entirely and thus erase the city's $540 million
unfunded OPEB liability.
[54]
San Bernardino, which
also filed last summer, has proposed cutting retiree
health payments while in bankruptcy.
[55]

When OPEB is unfunded (which, as we have noted,
is the case in most California communities), costs
in coming years are set to accelerate rapidly—likely
more rapidly than pension costs. When a worker retires and begins to draw benefits, his pension comes
out of the pension fund, whereas his health benefits
continue to come directly out of the operating budget. Thus, for as long as governments fund OPEB
on a pay-as-you-go basis, they will experience the
combined force of the baby-boom retirement wave
and rising health-care costs. In a prefunded system,
the effect is filtered.
[56]

Consider what Stockton was up against before it
adjusted OPEB in bankruptcy court (Chart 6).
Stockton's pay-as-you-go OPEB costs were set to
nearly triple between 2009 and 2019. The city itself
claimed that its "retiree medical benefit is one of the
most generous in the state."
[57]
CalPERS was Stockton's largest unsecured creditor ($147.5 million), and
its second-largest unsecured creditor was Wells Fargo,
the trustee for Stockton's $124.3 million in pension
obligation bonds.
[58]

Although the size of the overall liabilities is smaller,
managing the coming OPEB squeeze may prove
just as challenging to public officials as managing
pension costs.

III. WHAT IS TO BE DONE? THE REVENUE
QUESTION AND THE LEGAL QUESTION

Despite evidence that governments are in an
unsustainable spiral of spending for retirees,
a strong current of opinion continues to
interpret the California fiscal crisis as a revenue problem. In 2009, the state temporarily raised income,
sales, and car taxes. (The hikes had all expired by June
2011, after efforts to make them permanent failed.)

The November 2012 ballot features two tax-increase
initiatives: Proposition 30 and Proposition 38. Both
would raise income taxes and direct all new revenues
primarily to public education. Both contain spending restrictions to prevent the new revenues from
being used for unauthorized purposes. Opponents
have found these spending restrictions to be a "shell
game." As several argued in a statement in the state's
official voter guide, the legislature "can take existing
money for schools and use it for other purposes and
then replace that money with the money from the
new taxes…. Prop. 30 does not guarantee one penny
of new funding for schools."
[59]
Although Proposition
38's spending restrictions are tighter, they, too, are
vulnerable to the shell-game critique.

In light of the looming OPEB crisis, it is fair to ask:
Would more revenues be a bad thing? Perhaps what
some have alleged to be a weakness of Prop. 30—
that the real destination of its new revenues would
be retirement benefits, not schools
[60]—is a reason to
support it.

New revenues eventually will be needed to address
OPEB. But new revenues need not mean new taxes.
A fairer way to raise revenue for OPEB is glaringly
obvious: require current employees to contribute
to their future health care. In most of California's
government retirement systems, current employees
still pay nothing for their postretirement healthcare benefits.

Instead, it is popular this political season to promote increased taxes on higher incomes (as both
Propositions 30 and 38 would do). But high-earner
income is a uniquely poor source of revenue to support mounting OPEB costs because that income is
volatile. Wealthier people earn more money from
investments than do people in lower income brackets,
which means that this income fluctuates with the
ups and downs of financial markets. As long as new
tax revenue comes from high-income earners, it will
increase revenue volatility, already a well-documented
problem in California.
[61]

Governor Jerry Brown, Proposition 30's chief backer,
has focused on California public employees' retirement benefits as a problem. When he presented his
first tax-increase proposal last year, he paired it with
a plan for pension reform. The implicit promise was
"reform before revenue," but the pension bill that
Brown eventually signed into law failed to fulfill that
pledge for several reasons, not least because it did not
address OPEB.
[62]

Out of all these options, legislative action—changing
the retirement system's obligations by an act of law—holds the greatest potential for savings. But simply
changing the law on benefits represents a unilateral
reduction, and this is legally controversial.

Pensions for current employees and retirees in
California are protected by the "California rule."
Premised on the notion that pension promises
are implicitly contractual, this long-standing legal
doctrine mandates that all "detrimental changes" to
pensions, whether increasing employees' contributions or reducing their benefits, can be applied only
to new hires.
[64]

Is there such a thing as an implied contractual right
to OPEB? In principle, the answer is yes, according
to the most recent, definitive statement on the matter by the California Supreme Court (see sidebar).
[65]
However, the ruling does not establish that all existing retiree health benefits are protected to the same
degree to which pensions are. Local governments'
ability to adjust OPEB, for current employees and
retirees, remains unsettled in law.

Some systems have explicitly argued that retiree
health benefits amount to a "gratuity." Like a gold
watch at retirement, they claim, continuing health
benefits may be expected as a gesture of employer
beneficence and gratitude but not legally guaranteed.
Before 1974's Employee Retirement Income Security
Act (ERISA) changed federal law, it was commonfor corporations to insert exculpatory clauses into
retirement-benefits documents, to define pensions
as gratuities and thereby limit liability.
[66]
ERISA
forbade this; but ERISA does not apply to state and
local governments.

Some local governments in California have placed
exculpatory clauses like those once found in private
industry in their employee-benefit documents. In upholding Orange County's right to reduce OPEB this
past August, a U.S. district judge cited disclaimers
that Orange County had appended to its documents
over the years.

The legal confusion over what can and can't be done
about OPEB is a consequence of the unsystematic nature of retiree health-care benefits. Pensioncommitments are relatively unambiguous: what was
promised was a certain fixed percentage of the final
salary.
[70]
But retiree health care comes in a few different forms. A court that determines that retirees have
a contractual right to expect health benefits must
wade into another question: Which ones? Medigap?
Implicit subsidy? Part B reimbursement? Dependent
and survivor coverage? An explicit subsidy? And, if
the last, how generous do they have a right to expect?

What Has Already Been Done?

Given the financial and legal uncertainties, how can
governments get a handle on their OPEB costs? In
designing their approach to OPEB, local governments should look to their peers for what they have
done and for what they have not done. Cities that
provide nothing beyond the implicit rate subsidy
often have strikingly low liabilities. Among the 50
cities surveyed in Table 2, the average OPEB debt
per household is $1,736. Oceanside ($77),
[71]
Fresno
($532), Long Beach ($796), and Riverside ($597)
are all implicit rate subsidy-only cities, and all have
significantly lower levels of OPEB debt than their
peers. And none have begun to prefund: the sole
reason that their unfunded liability is so low is that
their benefits are less generous.

The implicit rate subsidy need not be the exclusive
retiree health-care benefit provided. An alternative is a hybrid model that offers a basic defined benefit (such
as an implicit rate subsidy) that is supplemented by
a defined-contribution benefit.

This is essentially Fresno's approach. The city provides an implied subsidy to its retirees and explicit
subsidies through its Post-Retirement Supplemental
Benefit (PRSB) program. PRSB takes the "gratuity"
concept seriously, by granting subsidies only when
Fresno's pension plan is overfunded. (It has been for
many years, which no doubt has helped sell this approach politically.) In the Fresno system, PRSB benefits are not only an effect of overfunding but a cause
of it because retirees have an incentive to keep their
pension plan well funded. The Fresno approach also
lets the city deal responsibly with pension surpluses.
At the moment, PRSB is in abeyance because of the
general slump in equities. The city's pension plan
remains overfunded, using official actuarial assumptions, but not enough to trigger OPEB payouts. Still,
the PRSB approach has proved itself over the years:
it provided monthly OPEB subsidies of $200–$300
per retiree even during the recent recession years.

Of course, overfunded pension systems are now quite
rare. A more practical approach for the current economy would be to establish a "retiree medical trust": a
collective defined-contribution plan for OPEB. The
Internal Revenue Service gives preferential tax status
to any compensation intended to pay for health care
in retirement. Structured properly, neither contributions by employer/employee into a retiree medical
trust nor withdrawals from it are taxed. A retiree
medical trust collects fixed pretax contributions by
employees, and sometimes the employer, during
workers' active employment. Cashed-in vacation
and sick leave may also be used in this manner.
[72]
Contributions are then pooled and invested. A board,
composed of employer and employee representatives,
would oversee the trust. The board sets benefits and
decides how to distribute funds in accordance with
asset levels and cost trends. As with any other definedcontribution plan, the employer, and thus taxpayers,
would not be liable.
[73]

In addition to seeking out the solutions that have
worked or could work, California cities should look
to their peers to understand the limits of certain
types of reform. This is especially important when
considering prefunding, which is part of the OPEB
solution but is not sufficient.

Los Angeles's experience illustrates the limits of prefunding alone. In that city, management of retiree
health care for general government employees has
been exemplary. OPEB and pension benefits for all
general city government employees in Los Angeles
are managed by LACERS, the Los Angeles City Employees' Retirement System. In the late 1980s, when
many state and local governments across the United
States were just beginning to address their pension
liabilities, Los Angeles started setting money aside
to prefund OPEB. Since 2006, Los Angeles has fully
funded its annual actuarially required contribution
to LACERS and was at least partially funding it in
previous years. As of its most recent actuarial valuation, LACERS' OPEB liability was 78.6 percent
funded, higher than many state and local governments' pension systems, including its own (which is
72.4 percent funded).
[74]

Even as it responsibly arranged to support OPEB, Los
Angeles also reduced benefits and required employees
to contribute. In 2011, the city capped its subsidy
at $1,190 per month per person for all employees
who retire after that year. If future retirees want to
exempt their benefits from the cap, they now must
contribute 4 percent of annual pay. It is a forwardlooking policy, in a state where most systems have still
not asked current employees to contribute anything
at all. Plenty of assets are available to fund benefits
in the short term, and L.A. is in the habit of making its annual required Contribution to its healthbenefit system. Mayor Antonio Villaraigosa wants
to go further with OPEB, cutting the current cap
in half (from $1,190 to $596), eliminating benefits
for dependents and raising eligibility standards for
reaching the maximum benefit.

Despite all this, Los Angeles still has an OPEB problem. Costs are still high and burdensome. Between
2008 and 2011, Los Angeles reduced its workforce
by about 4,100 employees (8.2 percent) while
spending, in FY2011 alone, about $100 million on OPEB for LACERS. Again, multiple overlapping
entities involve the same governments in multiple
OPEB dilemmas. While LACERS handles many
retirees from Los Angeles City government service,
two other systems are in place: one for fire and
police; and the other for the Department of Water
and Power. Hence the city's total OPEB expense in
2011 was over $350 million.

At $14,000 a year per retiree, LACERS benefits are
generous. It may well be that prefunding actually
enabled this excess. Perhaps benefits would not be
so rich under pay-as-you-go. Here, too, the experience of pensions is instructive. Had pensions still
been funded on a pay-as-you-go basis during the
dot-com boom in California, the overheated equity
market would not have tempted public officials into
unsustainable benefit increases.

The moral of this tale is that prefunding, while more
responsible and sustainable than pay-as-you-go, is
definitely not a magic bullet that can solve cities'
OPEB problem. If the LACERS approach is the
future, systems can expect to still be facing an OPEB
dilemma 30 years from now, even if they have started
prefunding and scaling back benefits (necessary actions that most systems have not even begun to take).
This is especially true in an environment in which
opponents of reform will do all they can to stave off
change. In March 2012, for example, the L.A. City
Attorneys Association sued the city over its $1,190
benefit cap.

This sort of political posturing is another reason that
cities should seek OPEB reform. A reformed system
frees up government time as well as government
money. Struggles over OPEB are a distraction—a
fight over benefits for those who no longer work for
the government—that takes energy and attention
away from government's actual work. Public officials
must spend political capital reforming retirementbenefit systems that could otherwise have been spent
solving problems that might make a difference in
citizens' lives.

Los Angeles's experience shows that revenues alone,
when unaccompanied by substantive reform, will
not be adequate. Were prefunding alone the solution
to OPEB, cities would not have a pension problem.

Conclusion

This paper has addressed the nationwide
fiscal crisis posed by government retiree
health benefits by looking at the acute
case of California. Though the press to reform
OPEB has been overshadowed by concern about
pension obligations, the health-benefit question
must be addressed. Governments will be pressured to maintain current benefits by raising taxes
and cutting services to constituents. They should
resist, because throwing money at the problem is
unfair and ineffectual. OPEB systems need reform
before revenue. What those reforms entail is quite
clear—and applicable beyond California, to the
whole nation.

The time is ripe for OPEB reform not only because
fiscal crises breed administrative opportunities but
because OPEB programs remain relatively undeveloped, much more so than pension systems. With
OPEB, governments have the chance to get it right
this time, by developing sustainable cost-sharing arrangements, funding practices and benefit structures
that avoid repeating the experience with pensions.
Specifically, the following steps should be part of
any OPEB policy:

Fundamentals: California state and local governments should reassess the need to offer OPEB.

It's frustrating enough that the soaring cost of health
care has forced state and local governments to lay off
some workers so that they can continue to afford to
pay for the benefits of others. It's even worse that
workforces are shrinking partly because of budgetary
pressure caused by delayed-compensation payments
to retirees.
It is time to question the premise of OPEB. Are retiree
health-care benefits necessary to attract and retain a
skilled workforce? Since the 1980s, private-sector
corporations have drastically cut back on retiree
health care. State and local governments have not done so. Perhaps the public sector knows something
that the private sector does not know. But governments should seriously consider that it may be the
other way around.

The costs of retiree health care are burdensome, and
the benefit is ambiguous. OPEB is clearly not a core
function of state and local governments. In the long
term, one part of the solution to the OPEB crisis in
California, as elsewhere, will be to shift the burden
of proof: rather than explain why they must provide
less OPEB than they once did, governments should
be pressed to explain why they must provide OPEB
at all.

Benefits: Think hybrid.

Cities should consider a hybrid model for OPEB,
which provides a scaled-back defined benefit pension
with a defined-contribution supplement. A hybrid
plan would reduce employer/taxpayer liability while
still providing retirees with a basic level of retirement
security. In the realm of pensions, several governments (Utah, San Jose, and Rhode Island) recently
have restructured their formerly pure defined benefit
pension systems into hybrid systems.

The defined benefit portion of a hybrid OPEB plan
need not include anything more than an implicit rate
subsidy. After all, the right of a retiree to remain on
his employer's group plan is a real, distinct benefit
worth thousands of dollars per year. Even when retirees receive no benefit beyond this, they still enjoy a
retirement benefit that most private-sector employers
do not provide.

The implicit rate subsidy could then be topped off
by premium support provided through a definedcontribution vehicle such as a retiree medical trust.
Employees and possibly their employer would make
tax-exempt contributions into a trust fund overseen
by management and labor. The value of the benefit would depend on the health of the trust fund.
Such a system would mean that taxpayers would
no longer be liable to make up shortfalls caused by
bear markets.

All reports on OPEB by policy centers, special commissions, government agencies, and scholars have
agreed about the benefits of prefunding. It is fairer
to taxpayers, more cost-effective, and—given rising
health-care costs—inevitable in the long run.

But where should the needed extra revenues come
from? Not every report addresses this question squarely.
New revenues could come from only two sources: the
employer, either through new taxes or budget cuts
elsewhere; or the employee, through contributions.

The latter is preferable, politically and morally.
Taxpayers are unlikely to support service cuts or tax
increases to fund benefits that most of them do not
enjoy. Today, most employees of most local governments in California do not contribute at all to their
OPEB costs. Instead, employees should be required
to contribute half the actuarial normal cost of their
retiree health care. Requiring employees to contribute
the actuarially determined half would generate new
revenues that could be invested through CalPERS'
CERBT or another irrevocable trust fund.

Current beneficiaries, the retirees, should also be
required to contribute. The unfunded OPEB liability that now burdens city budgets is associated with
benefits already earned. It would be unfair to ask
current employees to cover all that cost.

All new revenues raised should be deposited into an
irrevocable trust fund and invested.

Legal framework: The state legislature should
grant local governments special authority to break
through bargaining impasses over OPEB.

As we have seen, the legal status of OPEB commitments by governments remains unclear and could
remain so for some time. This uncertainty may hinder
efforts at reform. To head off this problem, the state
legislature could bring clarity to the issue by granting the same enhanced bargaining authority to deal with OPEB as it just granted to local governments
for pensions.

As part of the Public Employee Pension Reform
Act of 2012 just signed into law, California state
government set a 50/50 cost-sharing arrangement
(half of costs to be paid by the employer, half by the
beneficiary) for all state and local government pensions. The legislature provided local governments
with special authority to implement this arrangement
in the absence of a contract, when and if collective
bargaining comes to an impasse. State government
should implement the same 50/50 standard for
OPEB, as discussed above, and similar authority
should be granted to local governments.

In some cases, OPEB is formally bargained, in which
case governments have no choice but to negotiate
changes with unions. In others, the benefit is based in
legislation. In these cases, governments may have the
authority to adjust benefits unilaterally, but they may
not. As we have seen, the legal issues are unsettled.
Even in the worst-case scenario, where governments
would be forced to negotiate changes, enhanced
bargaining authority would provide a legal backstop
to prevent unions from blocking reform

Endnotes

1
OPEB stands for "other post-employment benefits," meaning other than pensions. In what follows, the term will be
used interchangeably with "retiree health care."

2
The Public Employee Post-Employment Benefits Commission, January 2008.

4
Agency for Healthcare Research and Quality, Center for Financing, Access and Cost Trends, 2011 Medical Expenditure
Panel Survey-Insurance Component, Table I.A.2.e(2011), "Percent of Private-Sector Establishments That Offer Health
Insurance by Plan Options and Insurance Offerings to Retirees by Selected Characteristics: United States, 2011." See also
"Employers Offering Retiree Health Benefits to Early Retirees: How Has It Changed?," Employee Benefit Research Institute, October 28, 2010; and "How Many Employers Offer Retiree Health Benefits to Early Retirees?," Employee Benefit
Research Institute, October 12, 2010.

5
The same drop-off occurs in the public sector. A 2011 survey of about 1,700 local governments by Cobalt Community
Research found that 70 percent of governments with 250+ employees provided retiree health care, but only 50 percent
did so among the 51–100 employee cohort, and this figure dropped even more among smaller governments; "Health &
OPEB Funding Strategies: 2011 National Survey of Local Governments," Cobalt Community Research, 2011, p. 29.

27
"Fact Sheet: Why Social Security and Medicare Are Vital to California's Seniors," AARP Public Policy Institute, July 2012.
For a detailed summary of all health-care costs in retirement, see Paul Fronstin, Dallas Salisbury, and Jack VanDerhei, "Savings Needed to Fund Health Insurance and Health Care Expenses in Retirement: Findings from a Simulation
Model," Employee Benefit Research Institute, Issue Brief No. 317, May 2008.

28
The Los Angeles City Employees' Retirement System (LACERS) estimates that the Cadillac tax will increase its unfunded
liability by $98.6 million and its annual required contribution by $3.3 million; "City of Los Angeles Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2011," p. 164.

33
Table 2 recalculates systems' pension liabilities using a 6 percent rate of return, as opposed to the more typical 7.75
percent. The methodology employed in this recalculation follows that of previous reports on pensions, such as Robert Novy-Marx and Joshua D. Rauh, "The Intergenerational Transfer of Public Pension Promises," National Bureau of
Economic Research, Working Paper 14343, September 2008; and Josh Barro and Stuart Buck, "Underfunded Teacher
Pension Plans: It's Worse than You Think," Manhattan Institute Civic Report No. 1, April 2010. The purpose of the
recalculation is to give a more accurate depiction of these systems' funded status (see discussions in "The Intergenerational Transfer of Public Pension Promises," and "Underfunded Teacher Pension Plans: It's Worse than You Think").
OPEB systems that are not prefunded use very conservative discount rates, and their liabilities have thus not been
recalculated. Prefunded OPEB systems use discount rates similar to those of pension systems. In Table 2, these systems'
liabilities have been recalculated when their rates exceed 6 percent.

34
These are not technically the top 50 biggest cities in California, as Irvine, Oxnard, Elk Grove, Salinas, Visalia, and Victorville are not included. For those cities, full data were not available on pension, OPEB, or debt totals, all of which were
necessary to ensure that the same cohort was used in Table 2 and Charts 1, 2, and 3. Accordingly, these six cities were
replaced by El Monte, Berkeley, Downey, Costa Mesa, Inglewood, and Ventura, the next six largest cities for which all
data were available.

36
San Francisco's liability is large because San Francisco city and county are one political entity. Thus, included in San Francisco's liability figures are a range of workers not included in other systems' calculations, such as airport and sheriff's
department employees.

37
"State of Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2011," pp. 20 and 166.

40
All "outstanding debt" figures in Chart 3 are taken from the "outstanding debt by type" table in the "statistical section" of each city's comprehensive annual financial report. Pension and OPEB liabilities are the same as those in Table 2.
Using an even lower, "risk-free" discount rate for pensions (5 percent or lower) would cause soft-debt totals in Chart
3 to increase. Also, cities have many other liabilities beyond the hard and soft debt discussed here. Examples include
long-term leases, derivatives, compensated absences, and environmental remediation obligations. All are enumerated
in cities' comprehensive annual financial reports.

41
What explains these disparities? One likely reason is that California municipalities offer less generous benefits. New
York cities often only require ten years' employment to be eligible for the maximum benefit (a practice called "cliffvesting"), whereas California cities typically impose a steady climb through several stages to reach full benefits. Then,
too, systems that offer only the less costly implicit rate subsidy seem to be more common in California. These tentative
explanations, though, should be replaced by further analysis of the disparities between state and local governments'
OPEB liabilities.

42
E. J. McMahon, "Iceberg Ahead: The Hidden Cost of Public-Sector Retiree Health Benefits in New York," Empire Center
for New York State Policy, September 2012, pp. 14–15 (table 3). New York City does not separate out its school- and
municipal-side OPEB liabilities so is not comparable with other cities in this sample.

43
Although New York's pension system is better funded than California's; "State Budget Crisis Task Force: California
Report," September 2012. For a similar survey of liabilities among Massachusetts cities, see Massachusetts Taxpayers
Foundation, "Retiree Health Care: The Brick That Broke Municipalities' Back," February 2011. However, OPEB liability
figures in this survey are not directly comparable with the New York and California figures because Massachusetts cities
include school employees in their OPEB totals.

44
San Diego County Taxpayers' Association analysis of Legislative Analyst's Office research, "Proposition 30: The Schools
and Local Public Safety Protection Act of 2012," August 2012.

62
Brown's initial 12-point pension reform plan would have made two modest changes to retiree health-care policy: first,
increase eligibility for new state government employees from ten to 15 years for minimum health-care benefits and
from 20 to 25 for the maximum. Second, Brown proposed addressing "the anomaly of retirees paying less for health
care premiums than current employees." State retirees are eligible for an employer contribution of up to 100 percent of
health-care premium costs (90 percent for dependents). The employer contribution rate to active workers' health care
varies by bargaining unit but is generally 80 percent; "A Preliminary Analysis of Governor Brown's Twelve Point Pension
Reform Plan," CalPERS, November 30, 2011.

63
For a recent survey of the literature on state and local governments' OPEB changes, see Joshua Franzel and Alexander
Brown, "Understanding Finances and Changes in Retiree Health Care," Government Finance Review, pp. 62–63. The
most comprehensive source is probably the annual summaries of retirement benefits changes published by the National
Conference of State Legislatures.

64
For an extensive discussion and critique of the California Rule, see Amy Monahan, "Statutes as Contracts? The ‘California Rule' and Its Impact on Public Pension Reform," Iowa Law Review 97 (2012): pp. 1029-1083.

65
Retired Employees Association of Orange County, Inc. v. County of Orange, Supreme Court of California, November 21,
2011.

69
Retired Employees Association of Orange County, Inc. v. County of Orange, U.S. District Court for the Central District of
California, August 13, 2012.

70
The only exception would be with COLAs. Recent court challenges to COLA reductions or eliminations have centered
on whether COLAs are part of the core pension benefit, finding generally that they are not.

71
Oceanside does contribute to retired firefighters' premiums.

72
Fresno, as well as Long Beach, also allows retirees to devote accumulated leave time to be devoted toward retiree
health care.

73
Examples of governments in California that have set up retiree medical trusts include Burbank, Santa Monica, Irvine,
and Elk Grove Unified School District. For more discussion of the mechanics of collective defined-contribution vehicles
for OPEB, see "Creating a Retiree Medical Trust (3d report, 2d ed.)," National Conference on Public Employee Retirement Systems, 2006; Girard Miller, "OPEB's Silver Lining: Unlike with Pension Fund Investments, Nothing Ventured
Means Nothing Lost," Governing, March 5, 2009; "Top 12 Pension and Benefits Plan Issues for 2009: Part II: Six More
New Paradigms for a New Year," Governing, February 5, 2009; and "A New Way to Save an Apple a Day: A Better
Voluntary Savings Vehicle for Retiree Health Coverage," Governing, April 23, 2009.

74
Both these figures are estimated based on an assumed 7.75 percent rate of return. Los Angeles has two other separate
retirement systems: the Department of Water and Power OPEB plan is almost (73 percent) as well funded, but the Fire
and Police OPEB plan is only 34.5 percent funded; "City of Los Angeles Comprehensive Annual Financial Report for the
Fiscal Year Ended June 30, 2011," p. 207.